The Debate on Discounting: Reconciling Positivists and Ethicists

Gollier, Christian, Chicago Journal of International Law

Abstract

Using a simple arbitrage argument, positivists claim that the interest rate provides the right basis to fix the discount rate to evaluate green investment projects. The real interest rate observed in the US during the twentieth century was around 1 percent. On the other hand, ethidsts estimate the discount rate using the marginal rate of substitution between current and future consumption. From classical estimations of intertemporal inequality aversion and prudence, assuming a 2 percent growth rate of consumption, they recommend a discount rate of around 3.5 percent. Ethicists are therefore less prone to investing for the future than positivists. I provide two roads to reconcile the two approaches. First, I claim that the positivist approach is correct if green investment projects are financed by a reallocation of resources from productive capital in the economy, whereas ethicists are correct if the projects are financed by a reduction in current consumption. Second, I claim that ethicists should use a rate between 1 percent and 2 percent to discount sure benefits that occur in the distant future to take the uncertainty surrounding the future prosperity of the economy into account. Finally, a risk premium should be added to the discount rate that is proportional to the socioeconomic beta of the investment project.

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Table of Contents

I. Introduction 550

II. The Positivist Approach 552

III. The Ethicist Approach 554

IV. The Risk-Free Rate Puzzle 557

V. Discounting Risky Projects 559

VI. Conclusion 561

I. INTRODUCTION

In their recent book, Climate Change Justice? Eric A. Posner and David Weisbach argued that issues related to distributional justice should not prevent us from pushing for effective policies to fight climate change.2 They suggested that climate change agreements that are aimed at solving all of the world's ills and, in particular, at redistributing wealth across nations, are doomed to fail.3 One particularly important issue is the problem of intergenerational justice, which is associated with the discount rate. In Chapter 7 of Climate Change Justice, Posner and Weisbach presented the two classical schools of thought for the determination of the discount rate: ethicist and positivist.4 The "ethicist position" attempts to reason from basic principles about what the discount rate should be. One of these principles is a preference for the reduction of inequalities among successive generations. In contrast, the "positivist position" uses the standard arbitrage argument to claim that the discount rate should equal the interest rate observed in markets.5 There is no doubt that Posner and Weisbach are inclined to support the positivist approach: "The positiviste are correct that choosing any project that has a lower rate of return than the market rate of return throws away resources.'"5

In principle, if markets are frictionless and complete, the competitive allocation of resources is efficient, and competitive prices provide the right signals to agents to decentralize this allocation. Applied to credit markets, this means that the allocation of consumption and wealth across time is efficient, and that the interest rate should be used to discount cash flows. In particular, as explained by Posner and Weisbach, the intertemporal rate of marginal substitution (IRMS) of consumption today and tomorrow is equalized at equilibrium to the real rate of return of capital, that is, to the interest rate.7 In other words, transferring consumption to the future by investing in capital has no impact on intertemporal welfare at the margin. In this context, Posner and Weisbach are perfectly right to claim that sacrificing current consumption to invest in projects that have a return smaller than the interest rate reduces intertemporal welfare and throws away resources.

However, we know that credit markets do not work particularly well. …

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